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The great rate debate

Peter Switzer
12 October 2009

Despite the fall in unemployment, the board of the Reserve Bank of Australia (RBA) are the biggest bunch of killjoys in the country, slugging new chums to the home loan caper with a rate rise that I think has been imposed too early in the piece. However, if they had waited until the right time to raise — early next year — the first rise might have been 0.5 per cent instead of the 0.25 per cent we have copped.

This pre-emptive strike on inflation, as the Big Bank justifies it, raises a series of important questions:

  • How many rate rises lie ahead?
  • How quickly will they come?
  • Should I fix my rate?

The simple answer to all three questions is really quite straightforward: “I don’t know!” However, I will let you inside my brain and show you how I would address these hip-pocket challenges.

What lies ahead

On how many rises lie ahead, let’s look to history. Before the RBA realised that they had underestimated the potential severity of the credit crunch and possible global recession, it was raising rates over 2008. Then when Lehman Brothers collapsed and was dumped by the US Government and other financial institutions, the Board has a Homer Simpson “Doh!” moment.

Five successive cuts slashed the cash rate down to three per cent from 7.25 per cent. This had created home loan interest rates around 9.5 per cent and they are now around five per cent... but that won’t last!

History shows that the cash rate is in the five per cent plus neighbourhood and that’s where the RBA would be thinking it is heading. That pushed home loan rates into the seven per cent neighbour hood.

The domino effect
So, let’s go to the question of how quickly?

Everyone in the economics caper passes themselves off as RBA watcher experts and its history is a guide. In the past, it has given rapid rises and so there could be another in November or December and then another in February followed by another.

That would take the cash rate to four per cent and then there should be a wait-and-see game. The questions the Big Bank would want answers for would be:

  • How is the economy going?
  • Is unemployment starting to fall?
  • What’s happening to inflation?
  • How is the global economy recovering?
  • What’s going on stock markets?
Cautious optimism

The majority consensus is that the recovery will proceed but there is debate over its strength. Locally, the RBA thinks we will go back to our trend growth of 2.5 to three per cent and that is big. It explains why they have moved early.

If the Big Bank’s guesses are right and the global recovery kicks in over 2010 and our economy is on song and strong, then I think the next stop will be the cash rate at five per cent by the end of 2011 — taking home loan interest rates to around seven per cent.

This is the optimistic economic scenario, however, if the global recovery is weak, then the timing of interest rate rises could be slowed down. If there is a double dip recession overseas, then stock markets would sell off and interest rates would, wait for it, fall!

As you can see, there are many ifs and buts in this interest rate prediction story, but in the current global economic setting there are heaps of ifs and buts as well.

To fix or not to fix

Now to the scariest question of all for a money commentator and financial planner: “Should I fix my home loan interest rate?”

The best time to ask that question was in January of this year and my answer would have been “yes” to anyone in too much debt, but since March the fixed rates have shot up. It now is a gamble but I have some solutions.

Doing some homework I found the CBA fixed rates were as follows:

  • One-year at 6.19 per cent
  • Two-year at 6.84 per cent
  • Three-year at 7.29 per cent
  • Five-year at 7.79 per cent
  • Seven-year at 8.29 per cent.

So if you were currently on a variable home loan rate at five per cent, which soon will be 5.25 per cent, going to 5.5 per cent by year’s end, and you apply my guesses on rate rises in a ‘getting better’ economic world, then by the end of 2011 the variable rate might be seven per cent and the fixed rate would be 6.84 per cent if you took it today.

Show me the money

By 2012, if all gets better, and that’s a big ‘if’, the home loan rate could be at eight per cent and the fixed is down at 7.29 per cent and you’re easily ‘in the money’, but you have been ‘out of the money’ for most of the time since you locked in. That is, you have been overpaying until the variable rate surpassed the fixed rate.

This is a gamble that only clearly pays off if rates rise really quickly and go up to nine per cent or higher and stay there. Once again, this is a gamble and that’s why I suggest two alternatives to a fixed rate.

Tighten the purse strings

One is a cocktail loan — say, half-variable and half-fixed — which cuts in half any rise in interest repayments when the cash rate goes up.

Second, you find out what you would pay if you fixed your loan and start paying that against your variable home loan. Provided you have a redraw facility on the loan, you can eventually draw out the money if repayments get too high for your cash flow and if you don’t need to redraw any money you have reduced the principal on your loan. The deal is very tax-effective. It requires discipline and it is best to do it automatically as an electronic transfer but this Clayton’s fix — the fix you have when you are not having a fixed home loan — is a good idea.

For advice you can trust contact Switzer Financial Services.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.


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